Oral Statement Concerning
Proposed Regulation NMS
Chairman William H. Donaldson
U.S. Securities and Exchange Commission
Before the U.S. House Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises
March 15, 2005
Chairman Baker, Ranking Member Kanjorski, and Members of the Subcommittee:
Thank you for inviting me to testify today on proposed Regulation NMS. All of the proposals included in Regulation NMS are designed to benefit and protect investors in the U.S. equity markets, and to facilitate efficient capital formation, by modernizing and strengthening the national market system. The national market system encompasses the stocks of more than 5,000 listed companies, which collectively represent more than $14 trillion in U.S. market capitalization held by investors. The Commission is committed to assuring that investors and public companies have the fairest and most efficient markets possible for these stocks, and I welcome your continuing interest in an issue of such vital importance to investors and the economy.
Given where we are in the process of considering Regulation NMS, my testimony today reflects my own views and not necessarily those of my fellow Commissioners. In this regard, I must point out that the Commission and its staff are currently in the final stages of deliberation on the NMS proposals, and the individual Commissioners continue to weigh the complex policy considerations presented by the proposals. I have not reached a final judgment on how to balance these considerations myself. Regardless of what the Commission ultimately decides, this Subcommittee and the public should have full confidence that the Commission has systematically and responsibly analyzed the relevant data and carefully considered the views of all commenters. Hopefully, my testimony today will convey some measure of the enormous amount of careful consideration that the Commission has devoted to these issues over the last several years and, indeed, continues to devote today.
In my written remarks I have described this intensive and comprehensive process. Prior to formulating the specific Regulation NMS proposals, the Commission’s review included multiple public hearings and roundtables, an advisory committee, three concept releases, the issuance of temporary exemptions intended in part to generate useful data on policy alternatives, and a constant dialogue with industry participants and investors. This process continued after the Commission published the proposals for public comment in February 2004. We held a public hearing on the proposals in April 2004, following which we published a supplemental request for comment to give the public an opportunity to respond to important developments at the hearing. The public submitted more than 900 comment letters on the original proposals, encompassing a wide range of views.
The insights of the commenters on the proposals, as well as those of the NMS Hearing panelists, contributed to significant improvements to our initial proposals. Consequently, rather than immediately adopting rules, the Commission reproposed Regulation NMS in its entirety in December 2004 to afford the public an additional opportunity to review and comment on the details. In response, the Commission has received more than 1500 additional comments, which we are now in the process of analyzing.
In my written remarks for the record, I have provided a brief overview of the four principal components of the Regulation. I have also attempted to place the Commission’s efforts in the broader context of fulfilling the mandate that Congress gave us in 1975 when it directed us, with “due regard for the public interest, the protection of investors, and the maintenance of fair and orderly markets,” to use our “authority under [the Exchange Act] to facilitate the establishment of a national market system for securities.” In particular, I discuss the insightful comment in the accompanying House Report that emphasized that “investors must be assured that they are participants in a system which maximizes the opportunities for the most willing seller to meet the most willing buyer.”
Because I understand that the Subcommittee is interested primarily in the trade-through aspect of our proposal, I will confine my oral remarks to this component.
I would like to make three basic observations on this topic, and then I would be happy to elaborate further on these and other aspects of Regulation NMS if that would be helpful to you.
First, I would observe that throughout the Commission’s deliberations over the trade-through rule, we have kept our eye on one overriding objective – the protection of investors – with particular attention to the concerns of small investors who may not have the resources to monitor the behavior of their agents, the brokers. The thrust of the proposed trade-through rule is actually quite simply stated: when an investor sends an order to a market, the market can either execute the order at the best price then being quoted in the national market system, or the market must send the order to the best quoting market. What does this mean? Two things. It means that a broker executing an order will be required to give that order the best price then available in any electronically accessible market, even if the broker internalizes the order or would prefer to trade in another market that may offer the broker itself, if not the customer, an advantage.
And second, it means that an investor who is willing to place an aggressively priced limit order on the book will not have his order ignored in favor of a less aggressively priced order. This second point is sometimes overlooked, so let me expand on it a bit. The investor who is willing to post a limit order supplies liquidity to the marketplace. The limit order shows the market where trading interest lies and helps to establish the best prices for stock trading. This investor provides a public service, and the market as a whole benefits.
But this investor acts at a cost to himself, for he reveals his trading interest, and he offers an option that any other investor can exercise simply by placing a market order. He risks having that option exercised only when the market is moving against him, and losing the trade when the market is moving away from him. His only compensation is the ability to trade when his quote is the best quote available. If he doesn’t get an execution, then he’s not compensated, and he will soon question why he posted the limit order. Worse, if he only gets an execution when the market is moving against him, we can begin to understand why he might choose not to offer the option to the market in the first place. A trade-though rule helps protect that investor for his willingness to supply liquidity to the market.
So the trade-through rule is, in the most fundamental sense, a rule that protects investors.
This simple point can get lost in all of the sound and fury unleashed by the vested interests for whom a market-wide trade-through rule would require new ways of doing business. I know that the members of this Subcommittee have been lobbied just as hard as I have on this issue, and I’m sure that you have asked yourself, as I have, just exactly whose interests are being advocated.
The second broad observation I’d like to make, is that I think it useful to note that much of the hue and cry over the trade-through rule is somewhat wide of the mark. The most strident criticism that we hear about the trade-through rule appears to focus on the existing ITS rule, a 35-year-old anachronism that has plainly outlived its usefulness. Let me be absolutely clear. The Commission is not proposing to validate or extend the ITS rule. Quite the contrary: the Commission has proposed a strengthened and modernized trade-through rule – one that would work.
The ITS rule is like a horse-and-buggy driving down the runway at Reagan National Airport. That’s because the key weakness of the ITS rule is that it doesn’t distinguish between an electronic quote – one that can be executed immediately – and a manual quote – one that requires human beings to negotiate. The ITS rule has made it difficult for electronic marketplaces to compete with floor-based exchanges, and in the process has helped floor-based markets maintain their competitive dominance. The Commission has proposed to fix that problem. The only quotes entitled to protection under the proposed trade-through rule are electronic quotes – quotes that are immediately and automatically accessible.
As so structured, the proposal addresses the main criticism that one hears about the ITS rule – that when a market is forced to send an order to New York, it languishes while the specialist decides whether to trade with it. That cannot happen under the rule the Commission has proposed. If the quote isn’t automatic, then it is not protected.
The proposal addresses other legitimate criticisms of the old ITS rule, such as the block-trade exception that results in the bulk of trade-throughs in listed stocks, and the weak and cumbersome “satisfaction” remedy that the old rule provides. In effect, the old rule does not prohibit trade-throughs – it merely tells a market that is traded-through that it can go and complain to the other market, and demand “satisfaction.” As you can imagine, such a weak remedy is weakly enforced.
The Commission’s proposed rule would eliminate the broad block exception in favor of more tailored benchmark and intermarket sweep exceptions, and would require market centers actually to install policies and procedures to prevent trade-throughs, instead of merely providing for an after-the-fact “satisfaction” remedy.
To my final observation, I want to emphasize that the trade-through rule that the Commission has proposed is pro-competitive – in the best tradition of the market-reform initiatives that the Commission has spearheaded over the last several years. As I explain in more detail in my written remarks, much of the public debate over the trade-through rule has focused on one type of competition – competition between markets. But we must remember that there are two kinds of competition that Congress has directed us to foster. One is competition between markets – like the competition between Nasdaq and Instinet, for example – and the other is competition between investors, or, as it’s usually called, competition between orders.
Both kinds of competition are essential for vibrant and healthy markets, as Congress recognized in 1975 when it told us to perfect the national market system. Some of the powerful market centers and professional traders most vocal in this debate seem to downplay order competition. But the Commission hasn’t forgotten that one of the great strengths of the U.S. equity markets is that the trading interest of all types and sizes of investors is integrated, to the greatest extent possible, into a unified market system. Such integration ultimately works to benefit both retail and institutional investors. Retail investors will participate directly in the U.S. equity markets, however, only to the extent they perceive that their orders will be treated fairly and efficiently. I am concerned about retail investors’ perception of unfairness when they display an order representing the best price for a stock, yet see that price bypassed by trading in other markets. A trade-through rule such as the one the Commission has proposed would help maintain the confidence of all types of investors in the U.S. equity markets.
I will conclude by offering a few thoughts on the future of the Regulation NMS rulemaking process. Although I cannot predict the final outcome, I do believe it is extremely important that there be an outcome, and that the outcome be reached soon. Many of the issues raised by the Regulation NMS proposals have lingered for many years and caused serious discord among market participants. These issues have been studied and debated and evaluated from nearly every conceivable angle. Few would seriously oppose the notion that the current structure of the national market system is outdated in many respects and needs to be modernized. The Commission must move forward and make decisions with regard to final rules if the U.S. equity markets are to continue to meet the needs of investors and public companies.
Although Nasdaq stocks are part of the national market system, some have suggested that the Commission should at this point adopt a trade-through rule only for exchange-listed stocks. Although this approach would preclude the possibility of unintended consequences in the Nasdaq market, this approach would have drawbacks that the Commission would need to consider carefully. One of the Commission’s goals in its years-long review of market structure has been to formulate rules for the national market system that adequately reflect current technologies and trading practices and that promote equal regulation of stocks and markets. This goal does not reflect a simple desire for uniformity, but is identified in the Exchange Act as a vital component of a truly national market system. The trade-through rule objective of promoting best execution of customer orders would be a particularly difficult benefit to set aside for Nasdaq stocks. I question whether ordinary investors should have to remember that their orders are protected by a Commission rule for exchange-listed stocks, but that caveat emptor still prevails in the Nasdaq market. The Commission will need to carefully consider whether, if a trade-through rule is indeed appropriate for exchange-listed stocks, its best-execution and liquidity-enhancing benefits should not be extended to Nasdaq stocks.
I can assure you that the Commission fully recognizes the far-reaching nature of many of the proposals. If adopted, some would require significant industry efforts to modify systems and otherwise prepare for the new regulatory structure. We are sensitive to these concerns and if the Commission chooses to adopt the rules, we will work closely with the industry on implementing them.
As I have emphasized, the Commission is still considering the Regulation NMS proposals, including all of the issues that I have discussed today. I look forward to hearing your views and answering your questions on the market structure issues facing the Commission, with the simple caveat that, as I am sure you appreciate, it would be inappropriate for me to attempt to prejudge where the Commission will arrive in its deliberations on these complex subjects.
Thank you again for inviting me to speak. I am happy to try and answer any of your questions.